Welcome to Thoughts on the Market.
I'm Paul Walsh, Morgan Stanley's Head of Research Product in Europe.
And I'm Marina Zavlak, Chief European Equity Strategist.
And today, our views on what 2026 holds for the European stock market.
It's Tuesday, December the 9th at 10am in London.
As we look ahead to 2026, there's a lot going on in Europe's stock markets.
From shifting economic winds to new policies coming out of Brussels and Washington, the investment landscape is evolving quite rapidly.
Interest rates, profit forecasts and global market connections are all in play.
And Marina, the first question I wanted to ask you really relates to the year 2025.
Why don't you synthesize your kind of review of the year that we've just had?
Yeah, I'll keep it brief so we can focus ahead.
But the year 2025, I would say, is a year of two halves.
So we began the year with a lot of kind of underperformance at the end of 2024 after US elections for Europe and the decline in the euro.
The start of 2025 saw really strong performance for Europe, which surprised a lot of investors.
And we had kind of catalyst after catalyst for that upside which was Germany's, whatever it takes.
Fiscal moment happened early this year in the first quarter.
We had a lot of headlines and kind of anticipation on Russia-Ukraine and discussions, negotiations around peace, which led to various themes emerging within the European equities market as well, which drove upside.
And then, alongside that, heading into Liberation Day, in the months kind of preceding that, as investors were worried about tariffs, there was a lot of interest in diversifying out of US equities and Europe was one of the key beneficiaries of that diversification theme.
That was a first half kind of dynamic.
And then the second half, Europe has kept broadly performing, but not as strongly as the U.S.
We made the call in March that European optimism had peaked.
And the second half was more kind of focused on the execution, on Germany's fiscal and post the big headlines, the pace of execution, which has been a little bit slower than investors were anticipating.
And also Europe just generally has had weak earnings growth.
So we started the year at 8% consensus earnings growth for 2025.
At this point, we're at minus one for this year.
So as you've said there, Marina, it's been a year of two halves.
And so that's 2025 in review.
But we're here to really talk about the outlook for 2026.
And there are kind of three buckets that we're going to dive into.
And the first of those is really around this notion of slipstream and the extent to which Europe can get caught up in the slipstream that the US is going to create, given Mike Wilson's view on the outlook for US equity markets.
What's the thesis there?
Yeah.
And thank you for the title suggestion, by the way, Paul, of Slipstream.
So basically our view is that well, our US equity strategist is very bullish, as I think most know.
At this stage he has 15 upside to his SP target to the end of next year and very, very strong earnings growth in the US.
And the thesis is that you're getting a broadening in the strength of the U.S. economic recovery.
For Europe.
What that means is that it's very, very hard for European equities to go down if the US market is up 15.
But our upside is more driven by multiple expansion than it is by earnings growth.
Because what we continue to see in Europe and what we anticipate for next year is that consensus is too high.
For next year, consensus is anticipating almost 13% earnings growth.
We're anticipating just below 4% earnings growth.
So we do expect downgrades.
But at the same time, if the US recovery is broadening, the hopes will be that that will mean that broadening comes to Europe and Europe trades at such a big discount about 26 relative to the US at the moment sector neutral that investors will play that anticipation of broadening eventually to Europe through the multiple
So the first point you're making is that the direction of travel in the US really matters for European stock markets.
The second bucket I wanted to talk about, and we're in a thematically driven market.
So what are the themes that are going to be really resonating for Europe as we move into 2026?
Yeah.
So let me pick up on the earnings point that I just made.
So we have 3.6% earnings growth for next year.
That's our forecast.
And bottom-up consensus is 12.7%.
It's a very high bar.
Europe typically comes in and sees high numbers at the beginning of the year and then downgrades through the course of the year.
And thematically, why do we see these downgrades?
And I think it's something that investors probably don't focus on enough.
It's structurally rising China competition and also Europe's old economy exposure, especially in regards to that China exposure where demand isn't really picking up.
Every year for the last few years we've seen this kind of China exposure and China competition piece drive between 60 and 90 of European earnings downgrades.
And looking at especially the areas of consensus that are too high, which tend to be highly China exposed that have had negative growth this year and prior years and we don't see kind of the trigger for that to mean revert.
That is where we expect thematically the most disappointment.
So sectors like chemicals, like autos, those are some of the sectors towards the bottom of our model.
Luxury as well.
It's a bit more debated these days, but that's still an underweight for us in our model.
Then German fiscal.
This is a multi-year story, German fiscal.
I mentioned that there's a lot of excitement on it in the first half of the year.
The focus for next year will be the pace of execution.
And we think there's two parts of this story.
There's an infrastructure fund, a 500 billion euro infrastructure fund in Germany, where we're seeing, according to our economists, a very likely reallocation to more kind of social related spend, which is not as great for our company's in the German index or earnings.
And execution there hasn't been very fast.
And then there's the defense side of the story where we're a lot more optimistic, where we're seeing execution start to pick up now, where the need is immense.
And we're seeing also upgrades from corporates on the back of that kind of execution, pick up in the need.
And we're very bullish on defense.
We're taking that defense.
Optimism and projecting out for all of Europe is that defense makes up less than 2 of the European index.
And we do think that broadens to other sectors but that will take years to start to impact other sectors.
And then a couple other things.
We have pockets of AI exposure in the enabler category.
So we're seeing a lot of strength in those pockets, a lot of catch up in some of those pockets right now.
Utilities is a great example, which I can talk about.
So we think that will continue.
But one thing I'm really watching and I think a lot of strategists across regions are watching is AI adoption.
And this is the real bull case for me in Europe.
If AI adoption ROI, starts to become material enough that it's hard to ignore which could start, in my opinion, from the second half of next year then Europe could be seen as much more of a play on AI adoption, because the majority of our index is exposed to adoption.
We have a lot of low hanging fruit in terms of productivity challenges, demographics.
You know the level of returns.
And if you track our early adopters, which is something we do, they are showing ROI.
So we think that will broaden up to more of the European index.
Now, Marina, you mentioned a number of sectors there as it relates to the thematic focus.
So it brings us on to our third and final bucket, in terms of what your model is suggesting, in terms of your sector preferences.
Yeah, so we have data-driven model, just to take a step back for a moment.
And our model incorporates it's quantum, mental.
It incorporates themes, it incorporates our view on the cycle which is in our view we're late cycle now, which can be very bullish for returns.
And it includes quant factors, things like price target revisions, breadth earnings revisions, breadth management sentiment.
We use a large language model to measure.
And, for the first time since inception, we have reviewed the performance of our model over the last just under two years.
And our top versus bottom stocks in our model have delivered 47 in returns the top versus bottom performance.
So now on the basis of the latest refresh of our model, banks are screening by far at the top.
And if you look whether it's at our sector model or you look at our top 50 preferred stocks in Europe, the list is full of banks.
And I didn't mention this in the kind of thematic portion, but one of the themes in Europe outside of Germany is fiscal constraints.
And actually banks are positively exposed to that because they're exposed to the steepness.
Specialists are definitely optimistic on the sector, but I think you're getting more and more generalists noticing that banks is the sector that consistently delivers the highest positive earnings upgrades of any sector in Europe and is still not expensive at all.
It's one of the cheapest sectors in Europe, trading at about nine times PE, also giving high single digit buyback and dividend yield.
So that sector we think continues to have momentum.
We also like defense.
We recently upgraded utilities.
We think utilities in Europe is at this interesting moment where in the last kind of six months or so it broke out of a five-year downtrend relative to the European index.
It's also if you look at European utilities relative to US utilities.
I mentioned those wide valuation discounts.
European utilities have broken out of their downtrend in terms of valuation versus their US peers, but still trade at very wide discounts.
And this is a sector where it has the highest CapEx of any sector in Europe highest CapEx growth on the energy transition.
The market has been hesitant to kind of benefit the sector for that because of questions around returns, around renewables earlier on.
And now that there's just this endless demand for power on the back of powering AI, investors are more willing to benefit the sector for those returns.
So the sector has been a great performer already, year to date, but we think there's multiple years to go.
Marina, a very comprehensive overview on the outlook for European equities for 2026.
Thank you very much for taking the time to talk.
Thank you, Paul.
And thanks for listening.
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